The issue of entity formation can actually have an impact on the form of entity chosen. Here's why.

July 14, 2011by Bill Harden, CPA, PhD

Correct choice at the beginning is a key to minimizing both tax and legal issues during the years of operations and at exit. Assuming that there are no legal reasons for preferring corporate over partnership or LLC structure, the partnership or LLC form will generally provide more flexibility in the tax world. This reasoning is based on the ability to convert to the corporate form from the partnership form without a tax hit as long as the requirements of §351 are met. However, the move from a corporation to a partnership would involve a corporate liquidation and a partnership formation, and the corporate liquidation portion would typically have a tax cost.

The answer to this question (How difficult is it to form an entity?) depends on several factors, the most significant of which is the type of entity to be created. A general partnership may be formed with no professional or filing fees at all. Of course, that is not the advisable way to form a general partnership, but it can be, and is, done with no written documentation at all. In contrast, a limited partnership must file a certificate of limited partnership with an appropriate state agency or official to protect the limited liability of the limited partners (that is, to give public notice of their status as limited partners). It is advisable, however, for both general and limited partnerships to have written agreements to define each partner’s rights and duties.

Corporations are created pursuant to state law. Generally this requires the assistance of a business attorney, although many self-help kits are available in the marketplace. Limited liability companies must also be created using the formalities of state law, thereby raising the cost of formation. Some advisors caution that LLCs can be more expensive to form than corporations because the operating agreement may need to be quite complex to deal with issues such as special allocations of tax items. The annual filing fees and state income taxes required by states also vary between the entities and across states.

As partnerships, for tax purposes, LLCs operating a business offer flexibility that cannot be matched by corporations, and it is true that taking advantage of that permitted flexibility requires a properly drafted, and perhaps costly, agreement. However, because taking advantage of the subchapter K flexibility is, in most cases, optional, the parties forming an LLC need not bear the cost of that flexibility unless they believe the benefits are of greater magnitude.

A note of caution is in order here. While it is tempting for some professionals who are not attorneys to assist their clients in drafting the corporate or partnership agreement documents, this is not an appropriate action for accountants in most states. The document preparation is considered the practice of law in most states. It is fine for a taxpayer to prepare these documents themselves, and an attorney is not a requirement although one is highly recommended. However, the accountant should not prepare these types of documents for their clients unless it is within the state’s scope of accounting practice.

At this same time, it is important that the accountant review the documents prior to their submission to the appropriate state agency for the entity’s creation. Many attorneys will not be versed in the federal tax issues involving a particular type of business. On the contrary, this ends to be the area of expertise of the CPA. These attorneys will typically have standard forms that are “safe” for use in that state and for federal tax purposes. These standard forms often contain language, however, that will provide for certain allocations, chargebacks, and offsets that may not be those the owners intend. For that reason it is best when the formation documents are prepared by an attorney in consultation with the CPA.

Technically, a partnership must have at least two owners. Certain states allow one-member LLCs, which are not taxed as partnerships. Instead, they are taxed as a “disregarded entity” resulting in Schedule C presentation on the individual owner’s return if the owner is an individual.

Tax Consequences of Formation

At initial formation of an entity, it is generally possible to transfer money and property to any type of entity without any tax consequences. This result is consistent with a variety of nonrecognition provisions found throughout the tax law and is based upon the theory that no gain or loss should be recognized when a taxpayer continues an investment in an alternative form.

That is, the owner is not viewed as having cashed out of the property held but rather as simply having changed his or her form of ownership of the property. The primary provisions of concern are §351, which relates to corporate formation, and §721, which relates to property contributions to a partnership. The former provision relates to corporations and contains one key requirement that is not found in the partnership provision, specifically control.

Allowing for nonrecognition of gain satisfies an important tax policy objective. The tax law should not create an impediment to a taxpayer’s choice of the appropriate form of doing business. Of course, to minimize potential abuses, the tax law has several exceptions to the general rule of nonrecognition of gain. These exceptions may suggest that one form of an entity is superior to another with regard to formative tax effects if there are differences in how the exceptions are applied to different entities. The next section reviews the basic rules for nonrecognition of gain from the transfer of property to an entity so that we may see how the differences can affect the choice of an entity.

It is important to remember that all entities may potentially be formed without recognition of any gain; therefore, the tax effects at formation are generally not an issue. The key exception to this rule occurs when the interests are granted in exchange for services rather than property and when contributions of property are expected to occur over multiple periods rather than at formation.

J. William Harden, PhD, CPA, ChFC, is an associate professor in the Bryan School at University of North Carolina Greensboro (UNCG). He is also currently in sole practice, focusing on taxation and financial planning for small businesses and individuals.